Posts Tagged ‘inflation’

The Fisher Paradox

November 24, 2014 2 comments

There is a bit of a paradox underlying much of monetary economics. If real rates are independent of monetary factors, then a reduction in the nominal rate should be accompanied by a reduction in the expected rate of inflation (or vice-versa). Yet we typically observe, at least in the short run, that if the central bank lowers its interest rate target, it causes a higher rate of inflation. Of course, both old monetarists and market monetarists reconcile this by saying “never reason from a price change” (always good advice) and instead, reason from a change in the money supply (and expected future money supply), assuming sticky prices in the short run and then separate the effects on interest rates into the well-known liquidity, income and Fisher effects which allows for the real rate to change in the short run and for the nominal rate to go either way.

That’s all perfectly reasonable but lately there has been a school of thought emerging known as “neo Fisherites” who are bringing this issue back into the discussion. Nick Rowe (for one) has recently been taking them to task(here, here and here).

Now let me say for starters that I suspect everything Nick says about these papers is correct, and I’m not trying to defend them. I agree that denying that lowering rates raises inflation is contrary to all observations, and I suspect (though I haven’t read them yet) that his analysis of the specific papers as lacking in economic intuition and relying on strange assumptions to “rig” the results in favor of their prior beliefs is most likely spot on. That is how I feel about most modern economic papers I read, sadly. However, I think beneath the snow job and the tiny pebble of wrongness, there is actually a kernel of insight (or at least the pebble started out as a kernel before it got all mangled and turned to the dark side) and it is closely related to the stuff I have been trying to say. So I will try to flesh it out a little bit in a way that does not contradict everything we know about how monetary policy actually works.

Note that this actually began as a discussion of monetary and “fiscal” policy, which I intend to get to but I will put that off for a future post since just dealing with this Fisher paradox will be enough to fill a lengthy post by itself, but keep in mind that adding that piece in will be important for making this model look like the real world. (And also keep in mind that I don’t mean what other people mean when I say “fiscal policy.” Frankly, it’s almost tongue-in-cheek. All macro is monetary.) Read more…


Is it Dedication to High or Low Inflation Which Leads to Communism?

July 31, 2014 3 comments

Nick Rowe has a post about the line between fiscal and monetary policy which largely reflects my sense of the matter which essentially is that the line is not very clear.  However, this part was the opposite of how I see it (sort of).

Too dedicated a pursuit of low inflation and the optimum quantity of money leads to communism, with government ownership of everything.

Also Scott Sumner echoed the same sentiment.  Since both of those guys are “at least as smart” as I am and have been at this a bit longer, this has got my wheels turning trying to reconcile their conclusion with my own and I think it raises several important points about the way I am thinking about this thing relative to them (and probably nearly everyone else).

First, I apparently don’t know what Sumner (and probably nearly everyone else) actually means when they say “fiscal policy” since I recently said something to the effect of: clearly a helicopter drop is monetary policy, but then in the comments, Sumner says this.

I’m strongly opposed to helicopter drops. I favor monetary stimulus when NGDP is too low. There is never any need for fiscal stimulus, even at the zero bound, and a helicopter drop is fiscal stimulus. It is wasteful and inefficient.

So I’m not sure where Scott’s line is.  To me, if the central bank printed money and dropped it from a helicopter, it would increase the supply of base money and this would be monetary policy.  Perhaps Scott is thinking that the government “borrows” from the central bank and then drops the money (or whatever they do with it), and so this increases the deficit and this makes it fiscal policy which may or may not then be offset by some monetary policy.  If that is the case, it is just a matter of who we are imagining doing the “dropping.”  To me this is splitting hairs, and not that important (which is basically the point of Nick’s post).   This post also deals with helicopter drops.

On a side note, I am not sure why Sumner objects on the grounds of inefficiency.  It can’t be a matter of changing the income distribution since he is such a bloody utilitarian after all.  This got me very puzzled so I went on his blog and looked for posts about helicopter drops and found this one which raises two possibilities for inefficiency.  One is based on the expectation that the government will someday raise taxes to pay off the money it dropped.  This also explains why it counts a fiscal policy.  The other is that it may cause peoples’ expectations about inflation to become unhinged and cause hyperinflation.

But that’s not really what I am interested in.  I’m not arguing for helicopter drops.  I’m trying to get at why we are at the ZLB in the first place and how monetary policy relates to the central bank ultimately owning stuff.  And I think this helps bring things into focus.

But if the Fed did accompany the drop with an explicit price level target, then the optimal helicopter drop would be less than zero.  Indeed if the Fed committed to say 4% inflation, the public would not want to hold even the current $2 trillion in base money (unless they were paid to do so with an interest on reserve program.)

That makes perfect sense.  If you hold the money supply constant, and increase expected inflation, people will want to hold fewer dollars at the current price level and so they will try to get rid of them by spending them which will drive up the price level.   Or at least this is how you would see it if you take the money supply as exogenous.

If you take nominal rates as exogenous, then an increase in inflation expectations, holding the nominal rate constant, will lower the real interest rate which will cause people to borrow more in order to buy stuff (both investment and consumption).  This drives up the price level and increases the money supply.  However, the interest rate regime can mimic the outcome in the money supply regime by raising the nominal rate to the point that the money supply doesn’t change.  Similarly, the money supply regime could expand the money supply until the nominal rate remained unchanged (or either of them could do something in between….or not in between for that matter).  That is not the important difference.

Either way you want to think about it, you have a tradeoff between the size of the money supply that is required to maintain a given price level and the expected rate of inflation.   If you are trying to hit a certain price level in the very short run, you can get there with a smaller money supply if people expect higher inflation in the longer run.  This seems to be the tradeoff between tight money and socialism that Nick and Scott have in mind and it is perfectly valid at any given point in time.  This instantaneous effect can be seen in my model as well (I’m pretty sure, although I can’t verify it right now due to technical difficulties…)

So essentially I have no argument with the way monetary policy functions in the short run.  My issue is about whether there is a stable long-run equilibrium.  This is where the relationship between money and debt becomes important.  If you think that money just floats around and has value solely because everyone believes that everyone else will always be willing to trade for it, then you imagine a demand for real money balances which depends only on the interest rate and output.  So if you can raise inflation, you can raise interest rates along with it and this will put you on a path where the desired money holdings will be smaller relative to the nominal value of output at all times.  Or in other words, the money supply will be higher but prices will be more higher and so the size of the central bank’s balance sheet in real terms will be smaller.

The point I am trying to make is that there is a sort of financial position that the economy gets into vis-a-vis the central bank when the central bank expands the money supply by expanding credit.  When they do this, they are essentially increasing the money supply by convincing people to lever up.  This can be done by either offering a lower nominal rate or convincing them that prices will be higher in the future.  Either one lowers the real rate of interest and makes it more attractive to go deeper into debt.  But this is not just more money floating around, it is more money and more debt which means that the public’s claim on the total money supply actually diminishes.

As an individual borrower, this works out fine as long as the central bank produces the anticipated inflation (0r more).  Then your income increases enough to repay the loans as expected and everybody wins.  But if everybody tried to repay their debts, the money supply would shrink which would mean that prices wouldn’t go up as anticipated.  So the central bank has to keep this from happening.  This means that they get into a pattern of perpetually lowering interest rates to further increase the money supply by increasing leverage and eroding the financial position of the overall economy.

Then one day they fail to produce the expected inflation, maybe because they hit the ZLB or maybe because they made a mistake, or maybe because people saw the ZLB coming and acted preemptively, or whatever and everything falls apart.  The reason it falls apart is because of the financial position of the economy.  It isn’t just that everyone suddenly thinks prices will only rise 1% instead of 2% so they start “hoarding” cash balances because the extra liquidity becames attractive at the lower inflation rate and this creates a death spiral (which is only “deathy” because prices can’t adjust fast enough to keep people from being laid off and output from falling).

It is that they think prices will only rise 1% instead of 2% and they took on a bunch of debt in anticipation of their income rising 2% which they now become concerned that they won’t be able to repay.  They start “hoarding cash” to repay the debts.  If they don’t, they will go bankrupt and lose real goods.  Since everyone else is in the same situation, everyone tries to grab the existing cash and pay off debts which causes the money supply to contract and prices to fall further until some combination of things restores the financial position of the economy to a point from which it can continue onward.

These things include:

1. Defaults.  This destroys debt without “destroying” money, which increases the ratio of money to debt.

2.  “Fiscal policy.”  This keeps the debt growing but it puts it on the government, so it can be done coercively (it doesn’t have to be individually rational).  This puts more money in circulation without increasing private debt.

3.  “Unconventional” monetary policy.  For instance a “monetary helicopter drop” by which I mean the central bank dropping money into the economy (a “fiscal helicopter drop” would then be when the government borrows money and drops it, in which case see number 2 above).  Or the central bank buying junk off of banks’ books for more than it is worth (this has some element of number 1 involved) or “adding zeroes” to their accounts, or buying up goods and services (rather than debt).  All of this will inject more money into the economy without increasing debt.  (We can throw dividends paid by the central bank into this category.)

So my point is that you can’t have what I would call a “long-run expansionary monetary policy” based purely on expanding credit.  You will need some combination of the above three things to keep the financial position of the economy on a sustainable path or to bring it back to such a path if it drifts away (as it is bound to do if you try to avoid those things for any extended period).

So in my model, it is not just about the willingness to hold cash balances, it is about the willingness to hold cash (or I would say “money” to include all balances denominated in dollars, or whatever) balances and the willingness to hold debt.  So to me the tradeoff between expansionary monetary policy and “socialism” is not just about how big the central bank’s balance sheet will have to be relative to the nominal value of output in a stable long-run equilibrium.  It is about how much of number 2 and 3 you would need relative to the value of output in a stable long-run equilibrium.  And I suspect that the more “expansionary” (the higher the intended rate of inflation), the more of this you will need in order to keep it from crashing.

Unfortunately, because of the previously mentioned technical difficulties, I  can’t show this in the context of the model at the moment.  But notice that there would be no such “socialism” necessary if there were no central bank in the first place and the money supply consisted of an exogenously determined quantity of some commodity like gold or silver.  In that case, there would almost certainly be some amount of deflation as the quantity of that commodity would most likely grow more slowly than output. (Or a better way of putting it: the rate of return on holding that commodity would have to be equal to the real rate of interest minus the liquidity premium and this would most likely be positive.  The selection of commodities which increase in quantity relatively slowly compared to output as money would happen endogenously.)

In this case, the private (excluding the central bank but not necessarily the government) claim on the money supply would always remain at 100%.  It is the adoption of a central bank which promises to create inflation by growing the money supply (by increasing credit/debt) which creates the gap between the money supply and the monetary wealth in the economy which has to be filled by some kind of non-credit injection of money or else closed by a wave of defaults.

Similarly, if the central bank just kept the rate of inflation (deflation) and the nominal interest rate equal to what they would be if it didn’t exist, it would do nothing, credit would not expand, the financial situation of the economy would not be eroded in any way and no “socialism” would be necessary.  It becomes necessary when they endeavor to expand the money supply by expanding credit.  The more inflation they want to create, the more they will have to do this and the more they will erode the financial condition of the economy in the absence of the three things mentioned above.  Or in other words, the more they will have to do those things to keep it going.  Or in still other words,  too dedicated a pursuit of high inflation and the optimal quantity of money leads to communism with the government owning everything.

Peter Schiff on Deflation

April 9, 2014 3 comments

A while back I sort of blasted Selgin for his position that deflation is not necessarily bad.  That was a bit unfair of me since he actually has a fairly nuanced and not totally unreasonable point.  If we had a monetary policy regime which caused deflation to not be bad (in other words, if we had one entirely different than the one we have) then it wouldn’t be bad.  But my reaction was sort of a knee-jerk response to a point of view that I run across often in libertarian circles that drives me nuts.

Here is the guy I was really arguing with.  So let me take out my frustration on him.  There is a lot that is wrong with this so I will try to knock off the really obvious but less important points first and work my way up to the big important stuff.  First of all, Schiff discusses an article on Bloomberg which he provides no link to.  IMO this represents a breach of blogging etiquette (there’s not a single link in the piece, it’s almost like he doesn’t expect the reader to question any of the bold empirical claims he is making).  Here is the link.

Postponing Consumption

Here is the argument.

 . . . there is now a nearly universal belief that deflation is an economic poison that works its mischief by convincing consumers to delay purchases. For example, in a scenario of 1% deflation, a consumer who wants a $1,000 refrigerator will postpone her purchase if she expects it will cost only $990 in a year. Presumably she will just make do with her old fridge, or simply refrain from buying perishable items for a year to lock in that $10 savings. If she expects the cost of the refrigerator to decline another 1% in the following year, the purchase will be again put off. If deflation persists indefinitely they argue that she will put off the purchase indefinitely, perhaps living exclusively on dried foods while waiting for refrigerator prices to hit zero.

That is a perfectly good debunking of a position that I don’t think anybody actually holds.  I dug out my intermediate macro text and I think I have identified what he is arguing with.  Here is Blanchard on the subject.

When inflation decreases in response to low output, there are two effects: (1) The real money stock increases, leading the LM curve to shift down, and (2) expected inflation decreases, leading the IS curve to shift to the left.  The result may be a further decrease in output.

We have just looked at what happens at the start of the adjustment process.  It is easy to describe a scenario in which things go from bad to worse over time.  The decrease in output from Y to Y” leads to a further decrease in inflation and, so, to a further decrease in expected inflation.  This leads to a further increase in the real interest rate, which further decreases output, and so on.  In other words, the initial recession can turn into a full-fledged depression, with output continuing to decline rather than returning to the natural level of output.  The stabilizing mechanism we described in earlier chapters simply breaks down.

Now I actually have a lot of issues with this theory.  For instance, it assumes irrational inflation expectations.  Also it assumes an exogenous change in output which causes inflation to fall.  I am actually inspired to explore these issues in a later post (this is not to say that economists are unaware of them).  But nowhere is it assumed that people, expecting prices to fall slightly, will decide to not consume at all.  There is a much more complex argument underlying this.  It involves a feedback loop between prices, inflation expectations and consumer demand which is certainly questionable.  But Schiff is not even scratching the surface of the actually questionable parts.  He is just seeing a result that he thinks is questionable (and is) and he is imagining that it is the result of a ridiculous formulation of the underlying consumer demand function (which it is not) and he is pointing out how ridiculous that demand function would be.  If this were what any economist had in mind, then he would have an excellent point.  However, I don’t think that is the case.

Sticky Wages (and “a change in demand is different from a change in quantity demanded”)

This is an area where I sort of agree with him.  The role of sticky wages tends to be exaggerated with a conspicuous lack of attention put on artificial (government) sources of stickiness like unions and minimum wage and price controls.  But he is going too far by claiming that these are the only source of price stickiness.  Certainly, at the very least, we can acknowledge that long-term contracts exist.  Plus there’s the whole debt thing that I’m always talking about (more on that later).  But what really betrays a failure to comprehend the sticky-wage argument is this.

However, inflation allows employers to do an end run around these obstacles. In an inflationary environment, rising prices compensate for falling sales. The added revenue allows employers to hold nominal wage costs steady, even when the raw amount of goods or services they sell declines.

This misses the point entirely.  He seems to be taking a decrease in the quantity sold for granted (reasoning from a quantity change?) and then treats the inflation as a completely independent phenomenon that just puts extra money in sellers’ pockets in spite of this decrease in order to allow them to keep wages high.

The actual argument behind sticky wages is not that the monetary authority has to cause inflation when the quantity of goods produced falls in order to keep wages from falling.  It is that they have to prevent prices from falling because wages can’t fall and that would cause the quantity of goods produced to fall.  This being due to the fact that employers could not continue to employ the efficient number of workers at the new, higher real wage.

So if we don’t start our reckoning by assuming that the thing we are trying to avoid happens exogenously (for no apparent reason), and instead we imagine that aggregate demand drops, perhaps due to unexpectedly tight monetary policy, we can make better sense of things.  In this case, demand for all goods would decrease.  This means that sellers would have to either reduce their prices or sell less or do both.  If all prices (including wages) were not sticky at all, they would simply lower their prices and wages until they were at the same quantity of sales and employment but at lower prices and wages.  But if they can’t lower wages, it will not be optimal for them to keep producing the same quantity at a lower price and the same wage.  This will cause them to cut back production (by laying off some workers) and lower prices until they are maximizing profits given the new lower demand and inefficiently high, sticky wages.

This, of course, can be avoided if the monetary authority avoids tightening, or in the case of aggregate demand (which is not the same as quantity) dropping for some other reason, by adopting a more accommodative policy to push it back up.  Is this a compelling argument for having a monetary authority manipulate the price level in the first place?  Maybe not, you decide.  But it is not a nonsensical argument and arguing with a distorted, straw-man version of it doesn’t get us anywhere.

And while we’re on the topic of Peter Schiff not really understanding what “demand” means, let’s deal with this:

Economists extrapolate this to conclude that deflation will destroy aggregate demand and force the economy into recession. Despite the absurdity of this argument (people actually tend to buy more when prices fall), . . .

There are two problems here.  One is that deflation doesn’t destroy aggregate demand, falling aggregate demand causes deflation.  I can forgive him for this because the textbook argument I cited above does actually give the impression that the causation goes both ways.  I think this is a problem with that exposition.  So I would be inclined to agree with his criticism if he didn’t blow it with the parenthetical statement.

This is econ 101 stuff.  The quantity demanded by a given consumer (or all consumers) is larger when price is lower and other things are constant.  This is different from a fall in demand!  Market prices are determined by supply and demand.  When demand falls, both price and quantity fall.  Aggregate supply and demand mean something a little different but the basic intuition is the same.  If your argument against the deflationary spiral is that “people buy more when prices fall” you are several layers of reasoning short of understanding the thing you are arguing with.

Debtors and Creditors

This is where it starts to get near and dear to my heart.  Schiff points out that inflation helps debtors but hurts creditors, giving the impression that it is simply a sterile transfer from one group to another with the implication that it goes on because the beneficiaries are more politically connected than those on the other side.

While it is true that inflation (by which I mean more than expected inflation) helps debtors and hurts creditors, this does not make the net effect neutral.  This is because people in aggregate are net debtors vis-à-vis the banking system.  So it is possible for us to all go broke together.  This is where my crackpot theories diverge from both the Schiff/Rothbard crackpot theories and from the “mainstream” (crackpot) theories.  So going into that in detail here would take us far afield but if you’re interested click here, here and here.

The Zero Inflation Boundary

Schiff gives the impression that, until this Bloomberg article, economists were only worried about negative inflation and that they only advocated low, positive levels of inflation because this provides a buffer against accidentally falling into deflation but that so long as this is avoided, there is no problem.  I don’t think this is an accurate characterization of the stance of most mainstream economists.

There are two separate issues here.  One is the question of the appropriate long-run policy regime.  This is where Schiff probably got this idea.  Most macro models have some version of money neutrality in the long run.  Often, this takes the form of superneutrality which means that the monetary authority can grow the money supply (and therefore the price level) at any rate they want without affecting the real economy in the long run. 

This leaves policy-makers (assuming they control the money supply) with the issue of selecting a long-run growth path for money and prices.  A natural argument, if you believe in sticky prices/wages, is then to say that a positive but moderate inflation target might be best because it allows for some cyclical fluctuation around the target without triggering the sticky-wage problem.  This, admittedly, is a lot like Schiff’s characterization of the mainstream position.  But this is not really the issue that most economists are concerned about when they warn about inflation being too low.

It is one thing to argue that the monetary authority could follow a zero-inflation long-run policy path and it would be no better or worse than a 2% inflation or 10% or -2% inflation path.  It is something else entirely when the monetary authority sets a 2% inflation target and then produces 1/2%.  It’s not that there is something magic about crossing the zero-lower-bound on inflation.  The problem is when inflation runs below expectations.

When people make long-term financial decisions, they do so with some expectation about future prices.  For instance, if you invest in producing a good, you have to predict the price of that good in the future.  If the price turns out to be lower than you thought, your calculations will be wrong.  There is not some eternal magic number that the price must be and the central bank has to make it hit that price or else cause a lot of problems.  It’s just that they have to not screw up peoples’ calculations by causing them to expect a certain price level and then causing a different level to occur.

This is particularly problematic when it goes on for an extended period of time without any attempt at filling in the gap.  The bigger that gap gets the bigger the difference between the actual price level and the level people were expecting when they initiated long-term financial positions in the past.  Plus if they go on like this for a while without changing their target, it starts to become unclear what to expect from them in the future.

This is mostly important for decisions involving nominal debt because, as I like to go on and on about, debt contracts are long-lived and nominally denominated so your obligation in nominal terms does not fluctuate with the nominal value of other things like your labor or your house or the output of your business.  And remember, aggregately, we are net debtors so when the price level grows more slowly than we were expecting, this causes a systematic weakening of the financial position of the economy as a whole.

This is my special way of characterizing the issue at the heart of the inflation question.  There are different ways of characterizing these issues and different models for trying to understand them but almost all of them rely in an essential way on the role of inflation expectations.  Peter Schiff is not even scratching the surface of these issues.


P.S. This is the most unimportant point and I originally put it at the beginning but it is probably also the most inflammatory and I figured some people might not make it past it to the more important stuff so I cut it out and stuck it here at the end.


Definition of “Inflation.”

This is a common sticking point for Rothbardians (which is what I am now using to refer to a particular popular sect often known as “Austrians” on the advice of commenter John S).  Economists almost universally use this word to refer to the change in the aggregate price level.  Rothbardians commonly assert that this is the “wrong” definition in the sense that it was not the original definition.  This is a completely pointless debate.

Usually this argument is brought up for one of two reasons.  One is to generally discredit mainstream economists and imply that they don’t know what they are talking about because they don’t even use the “right” definitions of words.  The other is to weasel out of hyperinflation predictions by saying “well, okay, prices haven’t really risen that much but that’s not the actual definition of inflation…”

I am no expert on the evolution of this term and I don’t care about it enough to research it but just for fun here is my educated guess of how things went down.  Originally inflation meant what the Rothbardians say it means because at that time, that was the most useful definition for thinking about the economy.  Eventually the state of economics evolved in such a way that someone had to give a name to the rate of change in the aggregate price level and they called it the “inflation rate” because they figured prices tended to be positively correlated (perhaps proportional) to the size of the money supply, other things being equal.  As the science continued to evolve, economists found themselves being very interested in the rate of change of prices and not so much in the money supply, except to the extent that it affected prices.

To see why this is reasonable consider the following thought experiment.  You need to make some investment/consumption decisions.  Maybe this is buying a house, or investing in the stock market or taking a new job or whatever, it doesn’t matter what it is.  An angel comes down from heaven and offers to do you one of two favors.  He will either tell you what the size of the money base will be in ten years (and not the price level) or he will tell you what the price level (somehow defined) will be and not the size of the money base.  Which would you prefer?

Before 2008, you probably could have at least argued that the choice was trivial because you could extrapolate pretty easily from one to the other but that notion should be dead now.  Of course, Rothbardians realize that what really matters is prices, their arguments are always actually about the price level.  They never say “we’re going to have hyperinflation of the money supply and you should be really worried about that even though prices will never rise more than 2% per year.”  When they make their inflation arguments, they are always talking about the price level.  It is only when those predictions don’t come true that they step into their time machine and act like the original argument that took place two years ago was really a hundred years ago and “inflation” didn’t really mean what you thought it meant.  And by the way, they weren’t really making a prediction because Austrians don’t make predictions so if you thought they were, you must have been confused.

When economists say “inflation” they are talking about changes in the price level.  All economists realize that this is what other economists mean.  If you want to use it in a different way, and be clear that this is what you are doing, because it allows you to say something interesting, I have no problem with that but if you are just ridiculing someone for using a word to mean what most people commonly accept it to mean, you are wasting everyone’s time.

Real Interest Rates, Hoarding, and the Zero Lower Bound

December 29, 2012 Leave a comment

A line at the end of a recent post by David Andolfatto got me thinking.

I want to stress, however, that while getting inflation and inflation
expectations back to target (and firmly anchored to target) may be a solution to
one problem, it is unlikely to be a solution to every problem currently facing
the U.S. economy. To put it another way, suppose that the current real interest
rate of -1% is too high relative to the current “natural” rate of -x%. Somehow
driving the real return on bonds to -x% may then help things a bit, but it does
nothing to address the more pressing question of why the “natural” rate is so
low to begin with.

I believe the theory I have tried (somewhat crudely) to lay out on this blog explains why real rates are below zero.  However, rather than try to give a complicated theoretical explanation for this phenomenon here, I will simply discuss some of the implications of this.  The difference being that interest rates, which are prices, are “caused” by more than one force (supply and demand), and are therefore complicated and elusive, especially when these forces are derived from expectations of variables at various points in the future.  Nonetheless we can look at investment supply in isolation and identify some things which must be true if the market rate is below zero, and I think noticing these things will help put this phenomenon into perspective.

Negative Real Interest Rates

If credit markets are in equilibrium, then the real interest rate must be equal to lenders’ marginal rate of substitution between consumption now and consumption in the future.  In other words, lenders must be willing to give up 1 unit of consumption today for 1+r (where r is the real interest rate) of consumption in the future.  There is pretty much no getting around this fact.  However, since utility functions are subjective, theory cannot tell us what they “should” look like, it can only assert certain shapes for them and see what those assertions imply.  Usually, they imply a positive real interest rate.

One way to imply a positive real interest rate is to assume a positive discount factor.  For many macro models, this is assumed to be constant, and therefore, implies a fixed (by assumption) real interest rate.  In a more realistic model, marginal utility is decreasing in consumption each period but agents are assumed to prefer consumption today over consumption tomorrow at a given rate (the discount factor).  This means that if consumption is constant over time, the real interest rate will be equal to this discount factor, but the real rate can be higher if people are expecting to be richer in the future since higher consumption then will mean lower marginal utility relative to today.  If they are expecting to be poorer in the future, they will be willing to transfer consumption to the future at a premium, since lower consumption implies higher marginal utility of consumption.

There is no economic reasoning which proves that people prefer consumption today to consumption in the future.  There is however a long history of observation to justify this assertion.  This observation being positive real interest rates in the face of rising consumption.  Similarly, there is no economic reasoning for assuming that people prefer consumption in the future to consumption today and since there is no significant history of observation that implies this there are few, if any, models which assume this.

So if people don’t arbitrarily prefer consumption in the future to consumption today, there is only one explanation for a negative real interest rate: people expect to be poorer in the future than they are today.  When this is the case, their marginal utility of consumption in the future (relative to today) will be higher because expected future consumption is lower.  Therefore, people will be willing to pay a premium to transfer some real wealth from today to some point in the future.  The negative real rate is implying that the market for investment reaches equilibrium before consumption is perfectly smoothed out between periods (with a positive discount rate, this could be the case even at a positive real rate, so long as it is below that discount factor).  In other words, this amounts to a market prediction of a recession.

Lower Bounds

It is widely recognized that there is a zero lower bound for nominal interest rates.  This is because negative nominal interest rates always open the door to arbitrage.  If the nominal interest rate is -1%, then (if possible) I could take out a trillion dollar loan, put 990 billion dollars under the mattress (metaphorically speaking) to pay it back in a year and go spend the extra 10 billion on whatever I wanted.  In other words, demand for loanable funds would be infinite.  It’s not so much that interest rates couldn’t be made negative but the market could not function in such a case, it would require an entirely different system of rationing.  There is no such lower bound with real interest rates, because they don’t allow for such arbitrage.  But there is a considerable amount of inertia around the zero level.  To see why, we must examine why the potential for arbitrage doesn’t exist as it would for negative nominal rates.

If the rate of inflation were uniform across all goods, then there would be potential for arbitrage with zero real rates.  Imagine that inflation were expected to be 5% and the nominal rate is only 3%, implying that the real rate is -2%.  If inflation is uniform across goods, then you could make a profit by taking out a loan at 3% and buying a durable good like gold and holding it for a period, then selling it after its price increased 5% and repaying your loan.  The reason this doesn’t work is that everyone enough people recognize this potential that they drive the price of gold up today and down in the future to the point where this arbitrage is no longer possible.  This point will be when the real return on gold is equal to the real return on other investments which is -2%.  If the price of consumption goods is rising at 5%, then the price of gold will have to rise at only 3% (the nominal interest rate).  This will be the case no matter how high inflation rates are expected to be.  If inflation is expected to be 100% and nominal rates are 3%, then gold will have to find a price where the expected increase is still 3% (assuming the real rate is still -2%).  Thus gold cannot be used to cash in on expected inflation.

Of course, if one happens to be holding gold when inflation expectations increase, the price will rise sharply.  But this rise should not be interpreted as a sign that it will continue to rise rapidly, even in the face of high expected inflation.  On the contrary, it should be seen as a sign that the price will rise more slowly.  Listen up all you Austrians, libertarians, and other gold-jockeys.

The effect of this is that a fixed quantity of gold will become more valuable in both nominal and real terms and therefore, it will take up a larger portion of peoples’ portfolios.  This reduces the quantity demanded of other financial assets which imposes some inertia on real interest rates.  Or to put it another way, people will take money out of bonds and other financial assets and put it into gold which will put upward pressure on the rates of those assets and tend to raise real interest rates.

But gold is not the only durable asset.  In a world of negative real interest rates, if you can buy consumer goods today and save them, you benefit.  If the price of canned food is expected to increase 5% and nominal rates are only 3%, then you are better off to buy the food today and store it than to invest the money and buy it in the future.  This of course, imposes additional costs such as taking up space and rotating stock that gold does not because canned food is bulkier and less durable than gold.  Nonetheless, this type of “hoarding” is a perfectly rational response to negative real interest rates.  The lower the rate, the more effort people will be willing to devote to this type of activity.  The result will be increased demand for canned food today and decreased demand tomorrow which means higher prices today and lower tomorrow.  Although the rate of increase will probably be greater than gold, it will be less than the rate for haircuts.

Goods which are not durable like haircuts, vacations, and nights on the town, cannot be stored so there is no way of mitigating inflationary effects on them.  The price of these will rise the most.


1.  Negative real interest rates imply that people expect to be poorer in the future than they are today (assuming no negative discount rate).

2.  Inflation is not uniform, it will be more severe the less durable/storable a good is.

3. “Hoarding” is a predictable economic response to negative real interest rates.

4.  The ability to convert wealth holdings into real assets that can be stored, exerts considerable inertia on real rates once they fall below zero.  The greater the ability to do this, the more inelastic the demand for other financial assets will become and the stronger the inertia will be.

Misconception #3: We are Experiencing Hidden Inflation

September 5, 2012 2 comments

The last one is the big one that should have blown your mind but nobody is commenting on it so if you missed it make sure you see Misconception #2.  This one is less profound but it is still important.  The hyper-inflation crowd is always pointing to food prices to argue that there is high inflation.  But this is dreadfully poor economics.  It’s true food prices are high but this is because there is a drought.  Similarly, gas prices are high because of turmoil in the middle east, government regulations which make it difficult/impossible to drill for oil or build a refinery (my oil-refining-friend insists that there will never be another refinery built in this country), and indirectly because of the same drought thanks to asinine ethanol standards.  But these are both increases in relative prices.  This is a distinctly different phenomenon from an increase in the price level (commonly referred to as “inflation”).

Furthermore, the use of core inflation (excluding food and energy prices) is not a plot to disguise high inflation.  And let me point out that I’m totally a believer in plots by “the establishment” to subtly misguide us, but this is not the case here.  How do I know this?  Because it doesn’t actually hide anything.  It turns out that if you want, you can just look up the headline inflation numbers.  Here is a post with some helpful graphs.  Notice how the only real difference between core and headline inflation is that headline is more volatile.  And most recently, it has been below core inflation.

There is a legitimate intellectual debate over whether core or headline inflation should be used by policy-makers but as far as I’m aware, “just going to the grocery store” has not received any serious consideration among stuffy academics like myself.  This is not a conspiracy.  There just isn’t high inflation.  If you understand Misconception #2, (or Thomas Jefferson) this shouldn’t surprise you because central banks cause first controlled inflation and then uncontrollable deflation.

Misconception #2: Money isn’t Backed by Anything

August 25, 2012 3 comments

If I had it to do over again, this would be number 1.  Even most economics textbooks don’t get this right.  They usually say something like “The only reason a dollar, or a franc, or a Euro has any value is because we have a stable system in which people are known to accept these pieces of paper in return for something valuable.”  This creates an impression of money as this worthless paper that is out there circulating around which, although it has no particular value to anyone, is somehow magically able to be exchanged for things which do have value.  There are two main intellectual consequences of this.

The first one is that many people come to the conclusion that this doesn’t really make sense which is true.  The second one, is upon coming to this conclusion, most people further conclude that because it doesn’t make sense, it won’t be able to go on forever and that when it fails, it will be because people, for some reason, become no longer willing to accept the money, having no particular value, in exchange for goods and services.  Or in other words: the money will become worthless.  Or in still other words: we will run into hyper-inflation.

This reasoning I find to be a fascinating study in what people are willing to question.  The thinking seems to be something like this:

1. Textbooks are correct.

2. A textbook says that this is why money works.  Therefore, this must be why it works.

3. But it doesn’t really make sense that money could work this way.

4.  Therefore, at some point, it must stop working.

As usual, the flaw turns out to be a false premise more so than false reasoning (though there is a bit of both).  If it doesn’t make sense for money to work like that, it wouldn’t be working now.  The real problem is that that explanation of why money works is completely bogus.  Once you relax the premise that the textbook must be right, things change dramatically.

The reality is that money is backed by debt (see misconception number 1).  Nobody owes you anything in return for your dollar (like they would if there were a gold standard for instance), but instead you most likely owe somebody dollars.  This serves a similar purpose.  For instance, if you have a $100,000 mortgage, then you can “convert” your dollars into your house at the rate of $100,000/house.  You don’t take the dollars down to the bank and turn them in for a house but if you fail to turn in your dollars for a few months, the bank will come to you and take your house.  This is not the same as a gold standard of course, but it is far from a situation where “money isn’t backed by anything.”

Now ask yourself: “if everyone else suddenly stopped being willing to accept money and the value of it plummeted, what would I do?”  Would you shrug and say “well I guess the dollar is worthless now” and start using your cash to blow your nose, wipe your butt and start fires to keep warm until the bank comes and takes your house?  Or would you go out and trade a loaf of bread for $100,000 and pay off your loan?  If you answered the latter, then consider that everyone else with a mortgage/car loan/boat loan/student loan/credit card debt would probably reason along similar lines and that the number of people finding themselves in that category comprise nearly the entire population of these United States and then realize that this is precisely why the dollar never suddenly becomes worthless.

Once you notice this fact, this should start falling into place.  Number 3 should go a long way toward explaining why recessions happen.

The Argument Gary North Has Been Waiting For Since 1933

August 8, 2012 2 comments

The nice thing about patronizing a not-so-popular blog: you get a lot of individual attention.  “Anonymous” (a very popular name here in the blogosphere…) directed me to this post by Gary North so I thought I would address it.  Here is the heart of his argument:

. . . (I)t is not possible for depositors to take sufficient money in paper currency notes out of banks and keep these notes out, thereby reversing the fractional reserve process, thereby deflating the money supply. That was what happened in the USA from 1930 to 1933. If hoarders spend the notes, businesses will re-deposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks. But the vast majority of all money transactions are based on digital money, not paper currency.

Today, large depositors can pull digital money out of bank A, but only by transferring it to bank B. Digits must be in a bank account at all times. There can be no decrease in the money supply for as long as money is digital. Hence, there can be no decrease in prices unless it is FED policy to decrease prices. Read more…